Author: csissoko

Matt Klein directs our attention to an exchange between Jason Furman and Dani Rodrik that took place at the “Rethinking Macroeconomic Policy” Conference. Both argued that, while economists tend to focus on efficiency gains or “growing the pie”, most policy proposals have a small or tiny efficiency effect and a much much larger distributional effect. Matt Klein points out that in a world like this political competition for resources can get ugly fast.

I would like to propose that one of the reasons we are in this situation is that we have rolled back too much of a centuries-old legal structure that used to promote fairness — and therefore efficiency — in the financial sector.

Right the way back to the birth of modern macroeconomics in the late 19th century, the promise of productivist national economic policy was that one could suspend debate about distribution in favor of “growing the pie”.

In Britain where this approach had its origins, access to bank credit was extremely widespread (at least for those with Y chromosomes). While the debt was typically short-term, it was also the case that typically even as one bill was paid off, another was originated. Such debt wasn’t just generally available, it was usually available at rates of 5% per annum or less. No collateral was required to access the system of bank credit, though newcomers to the system typically had to have 1 or 2 people vouch for them.

I’ve just completed a paper that argues that this kind of bank credit is essential to the efficiency of the economy. While it’s true that in the US discrimination has long prevented certain groups from having equal access to financial services — and that the consequences of this discrimination show up in current wealth statistics, it seems to me that one of the disparities that has become more exaggerated across classes over the past few decades is access to lines of credit.

The facts are a harder to establish than they should be, because as far as I can tell the collection of business lending data in the bank call reports has never carefully distinguished between loans secured by collateral other than real estate and loans that are unsecured. (Please let me know if I’m wrong and there is somewhere to find this data.) In the early years of the 20th century, the “commercial and industrial loans” category would I believe have comprised mostly unsecured loans. Today not only has the C&I category shrunk as a fraction of total bank loans, but given current bank practices it seems likely that the fraction of unsecured loans within the category has also shrunk.

This is just a long form way of stating that it appears that the availability of cheap unsecured credit to small and medium sized business has declined significantly from what it was back when early economists were arguing that we could focus on efficiency and not distribution. Today small business credit is far more collateral-dependent than it was in the past — with the exception of course of credit card debt. Charge cards, however, charge more than 19% per annum for a three-month loan which is about a 300% markup on what would have been charged to an unsecured business borrower in the 19th century. To the degree that it is collateralized credit that is easily available today, it will obviously favor the wealthy and aggravate distributional issues.

In my paper the banking system makes it possible for allocative efficiency to be achieved, because everybody has access to credit on the same terms. As I explained in an earlier post, in an economy with monetary frictions there is no good substitute for credit. For this reason it seems obvious that an economy with unequal access to short term bank credit will result in allocations that are bounded away from an efficient allocation. In short, in the models with monetary frictions that I’m used to working with equal access to credit is a prerequisite for efficiency.

If we want to return to a world where economics is win-win, we need a thorough restructuring of the financial sector, so that access to credit is much more equal than it is today.

I see that Tyler Cowen and John Cochrane are having an exchange about banking. First, Cowen expresses a nuanced view of banking, then Cochrane takes the opportunity to promote his narrow (aka equity-financed) banking proposal, and Cowen questions how successful equity-financed is likely to be in practice.

With my latest paper, I have something different to contribute to the discussion: a model of how banking — and the leverage of banks — promotes efficiency. From a macro perspective the argument is really very simple: we all know from the intertemporal Euler equation that it is optimal for everyone to short a non-interest bearing safe asset. (The Friedman Rule is just an expression of this fact.) The point of my paper is that we should understand banking as the institutionalization of a naked short of the unit of account.

How is this efficiency-enhancing? A naked short position requires you to sell something that you do not have. It is a means of creating a temporary “phantom” supply of what is sold, until such time as the short position is closed out. The Euler equation tells us that a “phantom” supply that supports short positions is exactly what the economy needs to achieve intertemporal allocative efficiency.

Of course, the problem with a naked short position is that if a short squeeze (aka bank run) forces the closure of the positions too early, bankruptcy will be the result. The paper is a careful study of what is necessary to make this role of the banking system incentive feasible, and finds (alongside many other studies) that competitive banking is inherently unstable. Two means of stabilizing banking in the context of the model are (i) the natural monopoly approach: permit a non-competitive industry structure, but regulate what banks can charge; or (ii) the central bank approach: set a lower bound on the interest rate banks can charge.

So I don’t think that Cowen really captures what banks do when he presents “transforming otherwise somewhat illiquid activities into liquid deposits” as the primary liquidity function of banks. In my model banks promote allocative efficiency by creating “phantom” units of account. But I think Cowen does capture a lot of the regulatory complexity that is created by the liquidity function of banks.

Cochrane is the one, whom I really think is working from the wrong model. I’ll go through his points one by one.

“1) We’re awash in government debt.”

So what. Unless the government is going to start guaranteeing private sector naked short positions in government debt, it doesn’t matter how government debt we have, because it will do nothing to solve the monetary problem. We need banks because they do make possible for the private sector in aggregate to support a naked short position in the unit of account (that’s what bank deposits are) and this is necessary for intertemporal allocative efficiency.

This view fundamentally misunderstands the settlement process in securities transactions. I responded to this view in a previous post and will simply quote it here:

Cochrane, because his theoretic framework is devoid of liquidity frictions, does not understand that the traditional settlement process whether for equity or for credit card purchases necessarily requires someone to hold unsecured short-term debt or in other words runnable securities. This is a simple consequence of the fact that the demand for balances cannot be netted instantaneously so that temporary imbalances must necessarily build up somewhere. The alternative is for each member to carry liquidity balances to meet gross, not net, demands. Thus, when you go to real-time gross settlement (RTGS) you increase the liquidity demands on each member of the system. RTGS in the US only functions because the Fed provides an expansive intraday liquidity line to banks (see Fed Funds p. 18). In short RTGS without abundant unsecured central bank support drains liquidity instead of providing it. (See Kaminska 2016 for liquidity problems related to collateralized central bank support.) In fact, arguably the banking system developed precisely in order to address the problem of providing unsecured credit to support netting as part of the settlement of payments.

Just as RTGS systems can inadvertently create liquidity droughts, so the system Cochrane envisions is more likely to be beset by liquidity problems, than “awash in liquidity” (p. 200) – unless of course the Fed is willing to take on significant intraday credit exposure to everybody participating in the RTGS system. (Here is an example of a liquidity frictions model that tackles these questions, Mills and Nesmith JME 2008). Overall the most important lesson to draw from Cochrane’s proposal is that we desperately need better models of banking and money, so we can do a better job of evaluating what it is that banks do.

“3) Leverage of the banking system need not be leverage in the banking system.”

Because the purpose of banking is to promote economic efficiency by providing society with “phantom” units of account, we need leverage in the banking system. What Cochrane calls “banking” cannot play the role of banks as I model them.

“4) Inadequate funds for investment”

My model of banking does not provide funds for investment — as least as a first order effect. My model of banking only provides funds for transactions. On the other hand, as a second order effect by promoting allocative efficiency, it seems likely that banks make investing more profitable than in an environment without banks. So an extension of the model that shows that banking promotes investment should not be difficult.

In short, both Tyler Cowen and John Cochrane are in desperate need of a better model relating the macroeconomy to banking. It’s right here.

So I’ve finally posted the paper I’ve been working on — a New Monetarist model of bank money — on SSRN. Warning for non-economists: lots of Greek in this one.

Here’s the title and introduction.

The Nature of Money in a Convertible Currency World

This paper studies the nature of money in an environment where the means of payment is convertible at a fixed rate into the numeraire consumption good. By focusing on this environment we eliminate the possibility that the means of payment changes value over time, and deliberately construct a situation where the price level is disabled as a means of equilibrating the supply of money with the demand for it. To our knowledge no one else has studied such an environment in a Lagos-Wright-type framework. Our goal in this paper is to demonstrate that in this environment the first-best can still be attained – if the means of payment is effectively a naked short of the unit of account.

A naked short has the effect of creating a “phantom” supply of the shorted object that disappears when the short is closed out. We demonstrate here that banks can create this “phantom” supply of the unit of account in the form of acceptances of private debt.[1] This type of bank liability is issued when the bank stamps a private commercial bill “accepted,” and the bank obligation is put into circulation when the borrower makes purchases. Then, when the borrower pays off the loan, the phantom supply of the unit of account along with the outstanding, but contingent, bank liability that was used to create it is closed out.

Why do we model the means of payment as a naked short of the unit of account? We argue, first, that this is the best way to understand the nature of the banking system in its developmental stages. Second, by modelling the means of payment in this way our model demonstrates the efficiency gains that can be created through the introduction of a banking system. Third, by carefully evaluating the incentive feasibility conditions for our bank money equilibria, we are able to relate the monetary system to banking stability. We find that the implementation of central bank monetary policy via interest rates can be explained by the need to stabilize the banking system. Finally, we also find support for the use of usury laws as a means by which policymakers choose amongst multiple equilibria to favor the interests of non-banks over those of banks.

The monetary system modelled in this paper is based on the 18th century British monetary system as described in Henry Thornton (1802) An enquiry into the nature and effects of the paper credit of Great Britain. Privately issued bills function as a means of payment because they are “accepted” as liabilities by the banks that underwrite the monetary system. While these bills were denominated in a gold-based unit of account,[2] as a practical matter there was no expectation that they would be settled in gold. Instead, they were used as a means of transferring bank liabilities from one tradesman to another. Thus, bills that are simultaneously private IOUs and bank liabilities are used to make payment. The non-bank debtor pays off her debt by depositing someone else’s bank-certified liability into her account. (The 18th century monetary system was the precursor of the checking account system and operates just like a system of overdraft accounts.) The bank’s liability on a deposited bill is extinguished when funds are credited to the depositor’s account.

In our model productivity is stochastic, and as a result the demand for money is stochastic. We show that the bank-based money described in our model can accommodate this stochastic money demand so that a first best is attained. Thus, our model can be viewed as a model of the “banking school” view where money is issued on an “as needed” basis at the demand of non-banks.

We argue that the convertible currency environment forces a reconsideration of the nature of money. Typically the monetary literature views money as “an object that does not enter utility or production functions, and is available in fixed supply” (Kocherlakota 1998). Shifts in the price of money equilibrate the economy in these environments. Historically, however, stabilization of the price of money by tying it to a fixed quantity of gold was a foundation of economic success in the early modern period (van Dillen; Bayoumi & Eichengreen 1995). Thus, we consider how money functions in an environment where its price is “anchored”. We show that a solution is for the means of payment to be a debt instrument that is denominated in the anchored unit of account and is certified by a bank. This solution is based on actual market practice in the early modern period.

This approach allows us to reinterpret general results such as Gu, Mattesini, and Wright (2014)’s finding that when credit is easy, money is useless, and when money is essential, credit is irrelevant. While their conclusion is correct given their definitions of money and credit, we argue that this standard definition of money is not the correct definition to apply to an environment with banks. We argue that the means of payment in an environment with banks is a naked short of the unit of account, which would be categorized in GMW’s lexicon as “credit”.

This paper employs the methods of new monetarism. Our model combines an environment based on Berentsen, Camera, and Waller (2007) with an approach to banking that is more closely related to Gu, Mattesini, Monnet, and Wright (2013) and Cavalcanti and Wallace (1999a,b). Our model of banking is distinguished from GMMW because non-bank borrowing is supported not by collateral, but by an incentive constraint alone, and from Cavalcanti and Wallace because our banks don’t issue bank notes, but instead certify privately issued IOUs. We find that for values of the discount rate that accord with empirical evidence, such a payments system can be operated with no risk of default simply by setting borrowing constraints.[3] We start by finding the full range of incentive feasible equilibria of the model, and then discuss how, when there are multiple equilibria, a policymaker may choose between these equilibria.

In this environment competitive banking is incentive feasible only when enforcement is exogenous. In the case of endogenous enforcement, competition in banking typically drives the returns to banking below what is incentive feasible and the only equilibrium will be autarky. This result is consistent with many other papers that have found that the welfare of non-banks is improved when there is a franchise value to banking (Martin and Schreft 2005, Monnet and Sanches 2015, Huang 2017. See also Demsetz et al. 1996).

Thus, the challenge for a policymaker is how to regulate competition in the banking sector so that banking is both incentive compatible – and therefore stable – and also meets the policymaker’s goals in terms of serving non-banks. One solution is to treat banking as a natural monopoly, allowing an anti-competitive structure while at the same time imposing a cap on the fees that can be charged by banks. This solution explains usury laws, which by capping interest rates at a level such as 5%, the rate in 18th century Britain, is able to generate both a robust franchise value for the banks that provide payments system credit and at the same time to ensure that a significant fraction of the gains created by the existence of an efficient means of payment accrue to non-banks. An alternate solution is to impose a competitive structure on the banking industry, but also to set a minimum interest rate as a floor below which competition cannot drive the price. We argue that this is the practice of modern central banks and thus that monetary policy should be viewed as playing an important role in preventing competition from destabilizing the banking sector.

Section I introduces the model of a convertible currency. Section II describes the equilibria of the model. Section III presents the equilibria using diagrams. Section IV discusses the means by which policymakers choose between the difference equilibria of the bank-based monetary system. Section V concludes.

[1] While it would be easy to reconfigure the means of payment to be deposits or bank notes, we believe the monetary function of bank liabilities in this paper is sufficiently different from the existing literature that it useful to present it using an unfamiliar instrument.

[2] For the purposes of keeping the exposition simple, assume that we model the monetary system prior to 1797 (when gold convertibility was suspended).

[3] Indeed, we argue elsewhere that the credit based on precisely such constraints constituted the “safe assets” of the monetary system through the developmental years of banking (Sissoko 2016). Treasury bills, the modern financial world’s safe assets, were introduced in 1877 and modeled on the private money market instruments of 19th century Britain (Roberts 1995: 155).

Monetary economics has a basic result: nobody wants to hold non-interest bearing fiat money over time unless the price level is falling, so that the value of money is increasing over time. Many, if not most, theoretic discussions of money are premised on the assumption that fiat money is an object and that therefore one can hold no money or positive quantities of money, but one can’t hold a short position in fiat money.

Maybe this is one of macroeconomics greatest errors. Perhaps the whole point of the banking system is to allow the economy as whole to hold a short position in fiat money. After all, from the perspective of a bank what is a bank deposit if not a naked short position in cash? And by lending to businesses and consumers banks allow the rest of us to be short cash, too. This makes sense, because the basic principles of intertemporal economic efficiency state that we should all be short cash.

Proposals for reform of the monetary system based either on public access to accounts with the central bank or on banking systems that are 100% backed by central bank reserves and government debt have proliferated since the financial crisis. A few have crossed my path in the past few days (e.g. here and here).

I have been making the point in a variety of posts on this blog that these proposals are based on the Monetarist misconception of the nature of money in the modern economy and likely to prove disastrous. While much of my time lately is being spent working up a formal “greek” presentation of these ideas, explaining them in layman’s terms is equally important. Thanks to comments from an attentive reader, here is a more transparent explanation. Let me start by quoting from an earlier post that draw a schematic outline of Goodhart’s “private money” model :

The simplest model of money is a game with three people, each of whom produces something another seeks to consume: person 2 produces for person 1, person 3 produces for person 2, person 1 produces for person 3. Trade takes place over the course of three sequential pairwise matches: (1,2), (2,3), (3,1). Thus, in each match there is never a double coincidence of wants, but always a single coincidence of wants. We abstract from price by assuming that our three market participants can coordinate on an equilibrium price vector (cf. the Walrasian auctioneer). Thus, all these agents need is liquidity.

Let the liquidity be supplied by bank credit lines that are sufficiently large and are both drawn down by our participants on an “as needed” basis, and repaid at the earliest possible moment. Assume that these credit lines – like credit card balances that are promptly repaid – bear no interest. Then we observe, first, that after three periods trade has taken place and every participant’s bank balance is zero; and, second, that if the game is repeated foerever, the aggregate money supply is zero at the end of every three periods.

In this model the money supply expands only to meet the needs the trade, and automatically contracts in every third round because the buyer holds bank liabilities sufficient to meet his demand.

Consider the alternative of using a fiat money “token” to solve the infinitely repeated version of the game. Observe that in order for the allocation to be efficient, if there is only one token to allocate, we must know ex ante who to give that token to. If we give it to person 3, no trade will take place in the first two rounds, and if we give it to person 2 no trade will take place in the first round. While this might seem a minor loss, consider the possibility that people who don’t consume in the first stage of their life may have their productivity impaired for the rest of time. This indicates that the use of fiat money may require particularized knowledge about the nature of the economy that is not necessary if we solve the problem using credit lines.

Why don’t we just allocate one token to everybody so that we can be sure that the right person isn’t cash constrained in early life? This creates another problem. Person 2 and person 3 will both have 2 units of cash whenever they are making their purchases, but in order to reach the equilibrium allocation we need them to choose to spend only one unit of this cash in each period. In short, this solution would require people to hold onto money for eternity without ever intending to spend it. That clearly doesn’t make sense.

This simple discussion explains that there is a fundamental problem with fiat money that ensures that an incentive compatible credit system is never worse and in many environments is strictly better than fiat money. This is one of the most robust results to come out of the formal study of economic environments with liquidity frictions (see e.g. Kocherlakota 1998).

In response to this I received the following question by email:

In your 3 person model, [why not allocate] a token to everybody? – I don’t understand how you reached the conclusion that “this solution would require people to hold onto money for eternity without ever intending to spend it”. If people have more units of cash than they need for consumption, the excess would be saved and potentially lent to others who need credit?

This question arises, because I failed in the excerpt from my post above to explain what the implications of “allocating a token to everybody” are when translated into a real world economy. In order for an efficient outcome to be achieved, you need to make sure that everybody has enough money at the start of the monetary system so that it is not possible that they will ever be cash-constrained at any point in time. In my simple model this just implies that everybody is given one token at the start of time. In the real world this means that every newborn child is endowed at birth with more than enough cash to pay the full cost of U.S. college tuition at an elite institution (for example).

Turning back to the context of the model, if the two people with excess currency save and lend it, we have the problem that the one person who consumes at the given date already has enough money to make her purchases. In short there is three times as much currency in the economy as is needed for purchases. What this implies is that we do not have an equilibrium because the market for debt can’t clear at the prices we have assumed in our model. In short, if we add lending to the model then the equilibrium price will have to rise — with the result that nobody is endowed with enough money to make the purchases they want to make. Whether or not an efficient allocation can be obtained by this means will depend on the details of how the lending process is modeled. (The alternative that I considered was that there was no system of lending, so they had to hold the token. Then when they had an opportunity to buy, choose to spend only one token, even though they were holding two tokens. This is the sense in which the token must be held “for eternity” without being spent.)

Tying this discussion back into the college tuition example. If, in fact, you tried to implement a policy where every child is endowed at birth with enough cash to pay elite U.S. college tuition, what we would expect to happen is that by the time these children were going to college the cost would have increased so that they no longer had enough to pay tuition. But then of course you have failed to implement the policy. In short, it is impossible to “allocate a token to everybody”, because as soon as you do, you affect prices in a way that ensures that the token’s value has fallen below the value that you intended to allocate. There’s no way to square this circle.

Connecting this up with bitcoin or deposit accounts at the central bank: the currently rich have a huge advantage in a transition to such a system, because they get to start out with more bitcoins or larger deposit accounts. By contrast in a credit-based monetary system everybody has the opportunity to borrow against their future income.

The problem with the credit-based monetary system that we have is that guaranteeing the fairness of the mechanisms by which credit is allocated is an extremely important aspect of the efficiency of the system. That is, in a credit-based monetary system fairness-based considerations are not in conflict with efficiency-based considerations, but instead essential in order to make efficiency an achievable goal.

Because of the failure to model our monetary system properly, we have failed to understand the importance of regulation that protects and supports the fair allocation of credit in the system and have failed to maintain the efficiency of the monetary system. In my view appropriate reforms will target the mechanisms by which credit is allocated, because there’s no question that in the current system it is allocated very unfairly.

The problem with proposals to eliminate the debt-based system is that as far as I can tell, doing so is likely to just make the unfairness worse by giving the currently rich a huge advantage that they would not have in a reformed and well-designed credit-based monetary system.

This morning’s procrastination included a few tweets and blogposts on the “women in economics” debate, and the twist the discussion is taking concerns me. Claudia Sahm writes about ” the toll that our profession’s aggressive, status-obsessed culture can take” and references specific dismissive criticism that is particularly content-free and therefore non-constructive. Matthew Kahn follows up with some ideas about improving mutual respect noting that “researchers are very tough on each other in public seminars (the “Chicago seminar” style).” This is followed up by prominent economists’ tweets about economics’ hyper-aggressiveness and rudeness.

I think it’s important to distinguish between the consequences of “status-obsession,” dismissiveness of women’s work and an “aggressive” seminar-style.

First, a properly run “Chicago-style” seminar requires senior economists who set the right tone. The most harshly criticized economists are senior colleagues and the point is that the resultant debate about the nature of economic knowledge is instructive and constructive for all. Yes, everyone is criticized, but students have been shown many techniques for responding to criticism by the time they are presenting. Crucial is the focus on advancing economic knowledge and an emphasis on argument rather than “status-obsession”.

The simple fact is that “Chicago-style” seminars when they are conducted by “status-obsessed” economists are likely to go catastrophically wrong. One cannot mix a kiss up-kick down culture with a “Chicago-style” seminar. They are like oil and water.

An important point to keep in mind is that a “status-obsessed” academic environment with a more gentle seminar style quickly degenerates into a love-fest for influential academics, whose skills frequently and noticeably degrade. In short, there’s a lot to be said for a tell-it-like-it-is culture, as long as the focus of that culture is on advancing knowledge and not on one-upsmanship.

One of the best descriptions I have heard of the “Chicago-style” seminar is that it’s a contact sport. Getting knocked to the ground is part of the game. You just pick yourself up and pay your opponent back in kind. And then you both head out to the pub afterwards to discuss the game, the sport, and solve the world’s problems.

Will some people be uncomfortable in such an environment? Of course. But some of us are uncomfortable in an environment where aggressively advocating a position is seen as rude or unscholarly. In any environment there will always be some people who are uncomfortable.

Do women tend to feel more uncomfortable than men in such an environment? Maybe. I have my doubts because I’m the kind of woman who’s often asking herself whether I’ve been too assertive, so I feel like I can finally relax when I’m around assertive people. I suspect that it’s patronizing to assume that women are more uncomfortable then men in such an environment — but I may be biased.

In short, “status-obsession” and the acceptability of denigrating behavior towards women and towards junior scholars without adequate patronage may well be a problem for the economics profession, but “Chicago-style” seminars are unlikely to be a major source of the profession’s problems.

Update: I should probably add that I have no direct familiarity at all with “Chicago” seminars, but only with those run by Prescott’s descendants. So maybe what I’m referring to is a “Minnesota-style” seminar. In any event, the rough and tumble of economic discourse seems to me essential to its progress.

Kudos to John Cochrane. To address criticism of his narrow banking proposal, he is willing in a recent blog post to “Suppose it really is important for banks to ‘create money,’ and to take deposits, and to funnel those into risky, illiquid, and otherwise hard-to-resolve assets.” He asks the question: How can we fund banks with deposits while at the same time ensuring that banks are easy to resolve? and argues that the solution is to issue the deposits not at the level of the bank (which funds itself only with equity), but at the level of a holding company whose only asset is bank equity, but which is funded by both deposits and equity. Resolution takes place when holding company equity is wiped out and remaining losses are put to depositors.

Cochrane misses the point about what it is that banks do. As I write in a hopefully soon to be published paper:

The fundamental problem of finance is that even though debt plays an important role in production and growth, what constitutes ‘safe’ debt for a lender is precisely the opposite of what constitutes ‘safe’ debt for a borrower. Because the future is uncertain, borrowing is safe when debt is long-term, unsecured, and expected revenues more than cover interest payment on the debt. Lending on the other hand is safe when debt is extremely short-term and grants the lender the immediate right to seize the borrower’s assets as soon as there is any risk of default. The banking system offers a modicum of safety to both lenders and borrowers, not just by transforming the maturity of the debt, but more importantly by placing the burden of loss due to default on the bank owners, whose interests thus lie in making the system of maturity transformation work.

Banking was able to develop in an environment where the owners and the managers of the banks were the same people — that is, banking developed in an earlier era without access to the corporate form and where unlimited liability was the norm. Thus, an important function of the liability structure of the bank was to align the interests of the owners — and originators of the bank’s assets — with those of the depositors. Depositors could only loose money after every single one of the bank’s owners had declared personal bankruptcy (for a famous 1878 example see here).

So what are the economic functions of a bank? First, to offer both lenders and borrowers an asset that is somewhat safe for each of them; and, second, to warrant the safety provided to the lenders by engaging to bear the first loss on any bad loans. A key function of banking is the alignment of the incentives of the originators of the illiquid, hard to value assets that finance entrepreneurial activity in the economy with those of the lenders who provide the funding for these loans. The fact that the originators bear the first loss is extremely important to the incentive structure of banking.

The U.S. experimented with corporate banking early in its history, but after a first major crisis that extended from 1837 well into the 1840s, adopted a modified form of the corporate structure. From the 1840s until the reforms of the 1930s U.S. bank owners typically faced double liability — so that an amount equal to the par value of the shares could be called up in the event that a bank failed. The assumption built into the 1930s reforms was presumably that bank regulators would be an adequate substitute for the incentives formerly created by the liability structure of the bank.

Thus, Cochrane’s plan has two flaws: First, he insulates the owners of the bank from the consequences of originating bad assets. Instead of being in a first loss position with respect to the bad assets, the owners share only proportionately in those losses. This structure ensures that their interests are not aligned with those of the depositors. Second, his system puts losses on bad assets in excess of holding company equity immediately to the depositors. But this surely means that the depositors will be unwilling to fund traditional illiquid, hard-to-value bank assets. Given the risk of loss, a reasonable depositor would surely insist that the bank’s portfolio be transparent and full of easy to value assets. As a result, Cochrane’s plan would almost certainly result less funding availability for traditional bank borrowers.

In short, while one appreciates that Cochrane acknowledges that his plan needs to address the role played by banks in ‘creating’ money, he has not yet mastered the ideas underlying this view of banking. I look forward to evaluating his next effort.